Economic Base Model

Pam Perlich
UBRPL 5/6020: Urban and Regional Planning Analysis
University of Utah
 Objectives
 Illustrate basic concepts via Keynesian
Circular Flow Model
 Define regional economic base model and
terminology
 Review economic base estimation methods
 Identify some limitations of the model
 Purpose of the Model
 Economic Base Models are used to understand
regional economic growth and development.
 Analyses from these types of models are used to
design, implement, and evaluate economic
development policies.
 Origins of the Model

 Urban and regional studies in sociology early in

the century
 Geography and planning in the 1950s
 Economic trade and macro theory in the 1950s
Keynes Responds to Classicals
 John Maynard Keynes was trying to explain the
causes, consequences, and potential policy
correctives for the Great Depression
 Classical economists had suggested that markets
would “self-correct”
– Wages, prices, and interest rates would fall to such a
low point that purchasing, hiring, and investing would
begin again and the economy would take-off
 Keynesian Critique of
Classical Economists
 Even if interest rates fall to low levels, businesses
will not invest because they do not want to
expand capacity during a depression.
 They will not hire labor, no matter how low the
wages, because there is no need to expand
production during a depression.
 When people have low wages, they cannot buy
products. This reinforces the downward spiral of
spending and income in a depression.
Circular Flow Model

Injections, withdrawals
and equilibrium
 The circular flow of income

Consumption of
domestically
produced goods
and services (Cd)
 The circular flow of income

Consumption of
Factor domestically
payments produced goods
and services (Cd)
 The circular flow of income

Consumption of
Factor domestically
BANKS, etc
payments produced goods
and services (Cd)

Net
saving (S)
 The circular flow of income

Investment (I)

Consumption of
Factor domestically
BANKS, etc
payments produced goods
and services (Cd)

Net
saving (S)
 The circular flow of income

Investment (I)

Consumption of
Factor domestically
BANKS, etc GOV.
payments produced goods
and services (Cd)

Net
Net taxes (T)
saving (S)
 The circular flow of income

Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV.
payments produced goods
and services (Cd)

Net
Net taxes (T)
saving (S)
 The circular flow of income

Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
 The circular flow of income

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
 The circular flow of income

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
 The circular flow of income

INJECTIONS

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
 Economic Base Model Collapses
All Spending into Regional and
Non-Regional

INJECTION

Export
expenditure (X)
Regional Purchases of
Factor regionally produced goods OUTSIDE OF REGION
payments and services
Import
expenditure (M)

WITHDRAWAL
Keynesian Cross Model
 Export Base Model Adapted
from Keynesian Cross
$200
$180
$160 NonBasic
Equilibrium Income
$140
Basic
$120 (Exports)
$100 Total Spending
$80 (NB+B)
$60 Income
(NB+Imports)
$40
$20
$0
$0 $50 $100 $150 $200

Export Base Multiplier = $100/$20 = 5 or 1/m or 1/.2

 http://www.rri.wvu.edu/WebBook/Schaffer/chap02.html
http://www.fgn.unisg.ch/eurmacro/Tutor/keynesiancross.html
 Basic & Non-basic

 Basic is production for export outside the region

 Non-Basic is production of goods and services
for consumption inside the region
– Population Dependent or Residentiary
 Total Economy = Basic + Non-Basic
 Export Multiplier

 An injection (export sales) increases income in

the area by an amount greater than the sale.
 This export multiplier is computed (in the simple
model) as 1/(Marginal Propensity to Import)
– Imports = MPI times Income
 Change in Exports times Multiplier = Total
Change in Income
 Multiplier is larger in a region that is more fully
developed (higher non-basic to basic ratio)
 Export - Led Growth
 Growth of the Export (Basic) sector drives the
economic growth of the region
 Non-Basic Economic Activity is population
dependent
 Growth of Exports => Growth of Non-Basic (or
Residentiary) Economic Activity
 Economic Growth => Population Growth
 Define the Region

 Must Define Region

 Evaluate trade flows & commuting patterns
 Economic Region as defined by the Bureau of
Economic Analysis
– Place of Work
– Place of Residence
 Bureau of Economic Analysis (BEA)
2004 Redefinition of Economic Areas
 Include:
– New OMB definitions of MSAs (Feb. 2004)
 Core Based Statistical Areas (CBSA) – urban core with populations of at least
10,000
 Metropolitan Statistical Areas (MSA) – have at least one CBSA with
population exceeding 50,000
 Micropolitan Statistical Areas – smaller CBSAs
 Combined Statistical Areas (CSA) – groupings of CBSAs that are economically
interdependent
– 2000 Census data – population and commuting
 Documentation:
– Johnson and Kort, “2004 Redefinition of Economic Areas,” Survey of
Current Business, November 2004,
http://www.bea.gov/bea/ARTICLES/2004/11November/1104Econ-Areas.pdf
 BEA Economic Areas
 Revised periodically (1974, 1977, 1983, 1995,
2004)
 One or more economic nodes
– Either Metropolitan or Micropolitan Statistical Areas
 Regional centers of economic activity
 Labor, product, and information markets
 Primarily defined by commuting patterns
– Serve as proxies for other markets
 Newspaper readership data are used in less
populated areas
– Audit Bureau of Circulations for 2001
Basic Procedures: 3,141 Counties
1. Metropolitan and Micropolitan Statistical Areas
are defined as nodes in the Core Economic
Areas (CEA)
– 344 Nodes
– 1,311 Counties
2. Balance of counties (1,830) assigned to the 344
CEAs
3. CEAs aggregated to 179 BEA Economic Areas
142: Salt Lake City-
Ogden-Clearfield
(Includes all Utah
counties except
Rich, Beaver, Iron,
Washington, and
Kane. Also includes
Franklin, ID and
Oneida, ID.)

92: Las Vegas-

Paradise-Pahrump
(Beaver, Iron, and
Washington)

58: Flagstaff, AZ
(Kane)
 Defining Basic Industries
 Agriculture
 Mining
 Tourism
 Federal Government
 Manufacturing (Partly)
 Non-Basic Industries
 Examples: Retail, Commercial, Banking,
Necessities
 As a region grows, it is able to support more non-
basic employment
 As a region grows, the ratio of non-basic
employment to basic employment increases
 Complications
 Goods & services sold to visitors
 Public transfers used by residents to purchase
goods and services (e.g., old age, unemployment,
agriculture, etc.)
 Traditional basic purchases that are actually
dependent on the level of regional activity
(purchases by business travelers, etc.)
 Basic Multiplier
 (Total Employment) / (Basic Employment)
 Total = Basic + Non-Basic
 “Company Towns” in rural areas have a relatively
small proportion of non-basic
 Larger, more integrated and developed areas have
much larger basic multipliers
 Use of Multiplier
 Estimates and projections of the base multiplier
allow analysts to calculate impacts.
 For example - if the basic multiplier for an area is
two, this means that for every new job in the
basic sector there will be an additional job created
in the non-basic sector.
 Units of Measure
 Production
– Final goods and services
– Income
– Value added
 Employment
– Full and part time job count
 Sales Revenues
– Double counting problem: wholesale & retail
 Employment Measures
 Most utilized in economic base estimation and
projection
 Reliable data source - ES202
 Over time
– productivity changes alter the ratio of labor to output
– ratio of income to jobs changes
– multiple job holding changes
 Growth Vs. Development
 Economic Growth
– Quantitative
– More of the same
 Economic Development
– Qualitative
– Structure changes
 Technological
 Market Changes
 Why Do Regions Grow?
 Comparative advantage => some industries locate
in an area and others do not
 Cost advantages
– labor
– materials
– transportation
– taxation / regulation
– proximity to markets
 Other Growth Factors
 Forward & backward linked industries
 Industry Clusters
 Quality of life
 Expectation of profit drives private capital
investment decisions
 Institutional context
 Labor and capital mobility
 Export Base Estimation
 Industries are not necessarily 100% basic or non-
basic.
 The share of basic in an industry may change
over time.
 Industries evolve over time.
 Structural change is difficult to model.
 Industrial Classification
 Old System: Standard Industrial Classification (SIC)
– http://www.osha.gov/oshstats/sicser.html
– Most recent revision: 1987
 New System: North American Industrial
Classification System (NAICS)
– http://www.census.gov/epcd/naics02/
– Introduced in the year 2000
– Most extensive and expensive revision ever
– Will cause breaks in time series
 Direct & Indirect Basic
 Direct Basic + Indirect Basic = Total Basic
 Direct Basic  exported out of the region
 Indirect Basic sell to direct basic firms
 Direct Basic + Indirect Basic = Total Basic
 Direct Non-Basic + Indirect Non-Basic = Total
Non-Basic (same logic)
 Assumption Approach
to Basic Sector Estimation

 An industry may be assigned to basic or non-basic

by assumption
 Mining is often assigned 100% to basic
 Local public schools are often assigned 100% to
non-basic
 Most industries are both
Location Quotient Approach to
Basic Sector Estimation
 Location Quotient = (Share of Subject Area’s
Employment in Industry i) / (Share of Reference
Region’s Employment in Industry i)
 LQ>1 => Specialization
 LQ>1 is not always basic (e.g., construction,
local public school, etc.)
 Basic Estimate: Location Quotient
Approach
bi = [(ei / Ei) - (et / Et)]  Ei
bi : basic employment in local area industry i
ei : total employment in local industry i
Ei : national employment in industry i
et : total local employment
Et : total national employment
 Location Quotient Approach

bi = [(ei / Ei) - (et / Et)]  Ei

Local Share Assumption: Local

of Industry Consumption Share

i’s production of Industry

i’s production
 LQ Approach Example
Employment in Total Industry Share of
Industry i Employment Area
Local Area 10 100 10%
Local Area
Share of Base 2% 1% N/A
Area
Base Area 500 10,000 5%

bi = [(ei / Ei) - (et / Et)]  Ei

5 = [(2%) - (1%)]  500
 LQ Calculation
Employment in Total Industry Share of
Industry i Employment Area
Local Area 10 100 10%
Local Area
Share of Base 2% 1% N/A
Area
Base Area 500 10,000 5%

LQi = [(ei / et) / (Ei / Et)]

2 = [(10%) / (5%)]
 Location Quotient Approach Logic

If (ei / Ei) = (et / Et)  Self-sufficient

 LQ = 1
If (ei / Ei) < (et / Et)  Imports
 LQ < 1
If (ei / Ei) > (et / Et) => Exports
 LQ > 1
 Location Quotient Equation

bi = [(ei / Ei) - (et / Et)]  Ei

bi = [Ei  (ei / Ei)] - [Ei  (et / Et)]

bi = [ ( ei / et ) - (Ei / Et) ]  et

Industry i’s share of Industry i’s share of

local employment national employment
 Productivity Adjustment

 If local industry is more productive, less labor is

required to produce each unit of output.
 If the local industry is more productive than that
of the nation, the location quotient understates the
degree of specialization in the industry.
 Consumption Adjustment

 If local area consumes a greater amount of the

output of the industry per employee of the
industry, the location quotient approach over
states the exports.
 Method 1: Population ratio replaces total
employment ratio.
 Method 2: Personal income ratio replaces the
total employment ratio.
 National Export Adjustment

 This location quotient approach assumes a

closed economy - no national exports of
products.
 If the nation is a net exporter in industry I:
– the method overstates the local area’s consumption
of the product of industry i and
– the method understates the local area’s basic
employment in the industry
 Cross-Hauling Adjustment

 The location quotient approach assumes no

importing of products from a basic industry.
 Cross-hauling (the importing of products for
local consumption in an export industry) leads
to:
– an overstatement of the local area’s consumption
of the product of industry i and
– an underestimate of the local area’s basic
employment in the industry
 Derivation of the LQ Formula
Local non-basic
1) ei = bi + ni
employment
in industry i

Local basic employment in industry i

2) bi = ei - ni
3) ni = ( Ei / Et )  et

Share of industry i in national employment

 Derivation (cont.)
4) bi = ei - [ ( Ei / Et )  et ]
Divide by Ei and rearrange terms

5) bi = [(ei / Ei) - (et / Et)]  Ei

Another way to estimate basic employment in industry i:

bi = [ 1 - ( 1 / LQ i ) ]  e i
 Minimum Requirements
Approach
 Developed by Ullman and Dacey in 1960
 Makes comparisons between similarly sized
(population) areas
 Accounts for differences in the sizes of regions
– Recall - smaller regions have a smaller share of non-
basic employment
 Reference Region for Minimum
Requirements

 Collect data for similarly sized (population)

areas.
 From among these, identify the the area that has
the smallest share of industry i in its total
employment.
 This is the minimum share region.
 Location Quotient Approach vs.
Minimum Requirements Approach

Location Quotient Approach

bi = [ ( ei / et ) - (Ei / Et) ]  et
Minimum Requirements Approach

bi = [ ( ei / et ) - ( emi / emt ) ]  et

Share of industry i in minimum share area

MR Approach Assumes that the Minimum
Requirements Area has No Exports

If (ei / et) = (emi / emt)  Self-sufficient

If (ei / et) > (emi / emt)  Exports

If (ei / et) < (emi / emt)  Imports

 Extensions to MR Approach

 sij = ai + bi (log10 Pj)

– sii = minimum share
– Pj = log of median population value for each
size category
 Larger population => must have a larger share to
have any employment classified as basic.
 Larger population => More will be classified as
non-basic => higher multiplier
 Minimum Requirements
Example
Assume: Local area employment is 100 and 10 of these jobs
are in industry i (10% share)

Compared to a minimum share for areas with similar

population sizes:
(10 / 100) compared to (5 / 100) => Basic = 5, Non-Basic = 5
Compared to a minimum share for areas with larger population
sizes:
(10 / 100) vs. (800 / 10,000) => Basic = 2, Non-Basic = 8
 Minimum Requirements
Given: sij = ai + bi (log10 Pj)
sii = minimum share larger area has more non-basic
production.
For higher population areas, the minimum share is larger.
Compared to larger areas, a greater portion of local area
employment will be classified as non-basic than if compared
with smaller areas.
Compared with larger areas as the minimum share region, our
multipliers will be larger because Non-Basic to Basic ratio
increases.
 More Extensions to MR
Approach
 Productivity adjustment
 May need to include a consumption adjustment parameter
as the method often overstates basic employment
 Summary
 According to the Economic Base Model, a
region’s growth is determined by the growth of
the export (basic) sectors.
 Approaches to estimating the basic content in
each industry include
– assumption
– location quotient
– minimum requirements